What Are the Causes of AIG Failure?

Did we realize the impact that  AIG would have on our economy?
Did we realize the impact that AIG would have on our economy? (Image: welt4 image by michanolimit from <a href='http://www.fotolia.com'>Fotolia.com</a>)

Not only was the AIG 2008 debacle larger than that at Enron, but for the federal government's infusion of capital—about $180 billion---it could possibly have brought down the whole financial system of the United States because of its size. As an important player in the insurance business, AIG decided it was smart enough to diversify into financial services where the risk is much greater than it realized. Little did the company realize that it would subject its shareholders and the national economy to abject pain.

Didn't “Stick to its Knitting”

Most insurance companies realize that covering the risks of their policyholders is what they are expected to do. So they set premiums based on a keen understanding of the risks they are undertaking, collect those premiums and invest them very conservatively so that they could pay the claims. Essentially, they live on the difference between premiums and risks. If you average out their performance over the years, they thrived. On the other hand, AIG saw the misguided opportunity for greater profits by creating other business under the banner of Financial Services. All went according to plan until the world economy suffered greater than during the Great Depression.


The Financial Services part of AIG grew from about $60 billion to over $200 billion from 1998 to the end of 2007. The parent company's income in 2005 was over $4 billion, about five times what it was in 1998. It accomplished that by investing in things like currencies and commodities, and selling what are called “swaps”, complicated transactions involving collateralized debt. But those investments became significantly depressed during the recession that took place beginning in 2008, so much so that AIG began having problems paying its insurance claims.


Some say that leverage could be the primary reason why an insurance company fails. Companies like Berkshire Hathaway and Montpelier Reinsurance have assets that are only twice the amount of their equity, a very conservative approach that those insurance companies take. But at the end of 2007, AIG's leverage was over eleven times the amount of its equity. It used the capital markets and borrowings to accomplish that, and it invested that money in highly speculative investments.

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